The UK’s top mandarin says economic recovery could take 20 years. It’ll be
quicker than that

In a speech this week, Britain’s top civil servant said that such were the challenges facing the UK economy, they could take 20 years to fix. There are lots of gloom-laden warnings like this around at the moment; indeed, compared to many of them, Sir Jeremy Heywood might even be seen as an optimist. Twenty years? Try 50, or maybe never.

The reality is that the path back to some form of normality may be rather swifter than this pessimistic consensus assumes. The economic challenges facing Britain are many and varied, but they fall into three broad categories, all of which are solvable.

First and most obvious is that of restoring growth to its pre-crisis trend of 2 to 3 per cent. This now seems to be happening much more quickly than anyone dared hope even a few months ago. The Office for Budget Responsibility’s (OBR) last forecast of growth for this year of just 0.6 per cent already looks out of date, with a number of independent forecasters prepared to stick their necks out in predicting 2 per cent or more.

Since the banking crisis came crashing in nearly six years ago there have been any number of false dawns, and this may well be another. Disposable incomes and living standards are still falling, so it doesn’t feel like a recovery even if the statistics say there is one. All the same, there are fewer reasons for thinking the recovery will again stall than there have been in the past.

The second challenge is the normalisation of interest rates. This is very much a work in progress; in fact, it has not really begun at all. Long bond yields have risen sharply in recent weeks, but this is more a response to warnings from the Federal Reserve in the US that it may soon cease money-printing than anything that’s happening here.

Both Mark Carney, the Bank of England’s new Governor, and his counterpart at the European Central Bank, Mario Draghi, yesterday signalled their determination to keep the lid on rising interest rate expectations with what is known as “forward guidance”.

It worked; bond yields in both Britain and Europe fell in response. If central banks can achieve these effects simply by indicating what they are likely to do, you wonder why they ever bother to act at all.

In any case, neither Britain nor Europe is yet ready for the discipline of more normal interest rates. Household, government and banking balance sheets remain too stretched to withstand such a shock.

Even so, rates are going to have to rise at some stage. We know from bitter experience that extended periods of negative real interest rates have some very unfortunate side-effects – bad debt forbearance, making it harder for the economy to grow, capital misallocation and asset bubbles, eventually culminating, as occurred in the banking crisis, in an almighty bust. Returning the economy to normal interest rates without upsetting the recovery is undoubtedly going to be tricky, but not impossible.

The third challenge is that of fixing the public finances, which was basically what Sir Jeremy was talking about when he spoke of a 20-year slog. In the short term, this is in fact not nearly as big a problem as it sometimes seems, for all that’s required is a little growth and the deficit will close quite quickly of its own accord. Continued growth once back in balance will then also over time shrink the national debt back to more sustainable levels relative to GDP.

The reason the Government has struggled to make progress thus far is not because it has fallen short on spending cuts. These have proceeded roughly as planned. Rather, it is that tax revenues, particularly income and corporation tax, have come in nowhere near as high as expected.

Again, return to growth will quite quickly solve this problem. Just as collapsing output caused the deficit to balloon as the economy headed into recession, the effect on tax revenues of even quite low levels of growth will cause it to shrink with equal vigour. Rising tax revenues from enhanced output will far outweigh the bigger debt-servicing costs that spring from commensurate increases in interest rates.

The more important challenge for the public finances is the longer-term one of the rising pension and healthcare costs of an ageing population. According to the OBR, these costs will, if nothing is done, again be putting upward pressure on the national debt from the mid-2020s onwards, with debt rising back to around 90 per cent of GDP in 50 years’ time.

What’s more, this may understate the true size of the problem, since the OBR bases its forecasts on some fairly heroic assumptions about the scope for productivity improvements in the National Health Service. While living high on the hog, Britain has not been saving enough, and continues to save too little, to pay for its old age.

Without the relatively favourable demographics that the present baby boom gives to these shores, the situation would look even worse. Countries with high debts need growing populations, and a ready supply of new taxpayers, if they are to sustain expected entitlements.

None of these challenges should be trivialised, but it is also important to keep a sense of proportion. Compared to many of the adjustments the UK economy has made in the past, today’s list of apparently insurmountable challenges looks relatively minor. And if these provide an opportunity for finally weaning the country off its post-war addiction to entitlement spending, they should be regarded more as a blessing than a curse.